With the successful development of Covid-19 vaccines, as well as continuing monetary and fiscal support across the globe, investors have begun to fear the return of elevated inflation for the first time in many years. Indeed, the recent Bank of America global fund manager survey revealed investors are now more concerned about inflation than developments in the Covid-19 pandemic.
In our view, there are four primary reasons why inflation is likely to spike higher in the near term – base effects as a result of the global lockdowns a year ago, the meaningful recent rise in commodity prices, strong pent-up demand and elevated savings rates, as well as the pressures stemming from the powerful stimulus packages unveiled over the past 12 months.
US Federal Reserve chairman Jerome Powell does not expect inflation to be sustainably higher over the longer term, suggesting most of the factors set to contribute to a near-term jump are largely one-off and unlikely to leave a lasting impact on core inflation. Nevertheless, fund managers must determine whether inflation might prove more persistent, which would elicit a reaction from central banks.
Upside risks to inflation include the unusually high money supply growth, which in the US is literally off the charts on a 150-year view. Even though central banks have indicated a willingness to let prices drift higher for a while, if inflation expectations become dislodged, it will take a huge effort by central banks to rein it back.
In a scenario where inflation expectations rise and become embedded, this could be quite destabilising for both bonds and equities. However, US Treasury secretary Janet Yellen has indicated the Fed will not allow inflation expectations to become dislodged, expecting the central bank to respond promptly and forcefully.
At the beginning of 2021, markets were not expecting a rate hike until late 2023, but this has since been brought forward to earlier in that year. Should inflationary pressures build even sooner than currently expected, the Fed may need to respond even earlier in late 2022. This again would likely result in meaningful downside for both bonds and equities.
If inflation follows the path suggested by Powell, with no policy adjustment needed, bonds and equities are likely to perform well from here. This was clearly the scenario anticipated by investors right up until February, before we saw markets sell off as the yield curve steepened and real rates climbed.
Troubles for traditional diversification
When the fiscal policy ambitions of the new Democrat administration in the US became clearer during the early part of January, our models suggested markets were meaningfully overestimating the ‘Goldilocks’ scenario of merely temporary inflationary pressures.
Therefore, we positioned our portfolio for a meaningful steepening of the yield curve and a sell-off in fixed income, which proved fortuitous. As real rates continued to move even higher in February, we also cut our equity positioning, with our equity beta dropping from 0.65 to about 0.25 over the course of the month.
While we have since taken some profits on our short bond exposures, due to the sizeable moves, we remain modestly net short, on the view the yield curve is likely to steepen further over the course of 2021. As for equities, even though our net exposure has been reduced, the remaining positioning is largely cyclical. This is primarily in commodity-sensitive markets such as Canada and Australia – as well as Japan, which tends to do well during a global upswing.
As for currencies, our exposure is also oriented towards commodity-sensitive currencies – with the Canadian dollar and the Australian dollar our two longest positions at the beginning of March.
Moving forward, it will be important for investors to carefully monitor the role sovereign bonds play in a diversified portfolio – particularly government bond markets within the G10. In our view, these exposures offer significant levels of risk, with very little return to compensate. For example, some government bond markets – such as Germany and Japan – offered little protection when equities markets were aggressively tumbling in March 2020.
With significant uncertainty surrounding inflation, investors are taking on tremendous risk with sovereign bond allocations. Where we historically relied on sovereign fixed income for diversification, we now seek alternative tools, such as trading safe haven currencies, or utilising short equity or commodities exposures.
Sushil Wadhwani is portfolio manager of the PGIM QMAW Keynes Systematic Absolute Return fund. He is also a former member of the Bank of England’s Monetary Policy Committee (June 1999 to May 2002)
